Information Transmission, Nonlinearity and Volatility Behavior of Precious Metals in the Presence of Oil and Exchange Rate Shocks

ABSTRACT: The recent shock waves due by devastating and contagious crises in both the stock and commodity markets over the last few decades have driven individual investors, institutions, as well as entire countries to bankruptcy. Smart investors have realized and therefore seized the potential advantages inherent in alternative investments particularly in precious metals. In this study, we investigate information diffusion, nonlinearity and chaotic structure in a regime changing environment, volatility convergence and persistence, and information asymmetry in these precious metal prices in the presence of oil and exchange rate shocks. Under the prefix that our selected precious metals (gold, silver, platinum and palladium) move in tandem when exposed to similar macroeconomic fundamentals, we use the Vector Error Correction Model (VECM) to analyze the long run relationship amongst these precious metal prices. On nonlinearity and chaotic structure in a regime-switching environment, we use the Bayesian Markov-Switching vector error correction (MS-VEC) model and the regime-dependent impulse response functions (RDIRF) to examine the transmission dynamics between these commodities. Finally, we use the GARCH (2, 2) and the Threshold-GARCH (2, 2) models to investigate volatility persistence and convergence, as well as the impact of asymmetric (positive and negative) shocks on the precious metal prices. We maintain consistency by using the same long range high frequency data from 1987 to 2012 for the entire study. Moreover, we use compelling time series techniques for the analysis as well as consider the structural breaks and shocks inherent over the span of our sample. We find a co-integration relationship between these variables as well as significant short term interactions both pre and post 2007/2008 financial crisis. We find compelling evidence that gold is most informative in the group over the entire sample period. Rising oil prices is seen to be pro-cyclical with precious metal prices mainly post crisis since it is a complement in precious metal production. Platinum price changes explain changes in palladium price returns but the reverse is not true. Furthermore, two regimes (low and high volatility regimes) appear prevalent for this study. Gold prices are clearly the most informative in the group in the high volatility regime, while gold, palladium, and platinum are the most informative in the low volatility regime. Moreover, although the platinum and palladium prices impact each other, the impacts in the high volatility regime are asymmetric. In addition to its low correlation in the group, palladium’s negative impact on the exchange rate and gold makes it a reliable hedge asset for investors. Gold is the least volatile variable, thus affirming its use as a “safe haven” asset, while silver and oil are the most volatile in the group. Regarding volatility behavior of precious metals, there is slow convergence or high persistence for the investment and monetary assets (gold and silver) than the more industrial commodities (platinum and palladium). Gold and silver are seen to adjust more quickly to shock that their industrial counterparts. In addition, gold and silver portray asymmetry regarding good and bad news on the conditional variance. Although both gold and silver exhibit resistant to the AFC, silver is a lot more vulnerable than gold as seen by the news impact curves. This may be a result of the lost monetary element of silver which has become more of an industrial than a monetary unit over the past decades. Gold and silver show some leverage effect while platinum and palladium show insignificant leverage effect. Although there are possible extensions to this study, many stakeholders will benefit significantly from the results of this study. International investors may consider including palladium in their precious metal portfolios since its low correlation makes it a good hedge asset. Particularly during high volatility regimes, investors of precious metal, central banks and other stakeholders should watch gold and oil prices carefully especially due to their high information content in determining the direction of change in the other commodity prices and exchange rate, and its ability to act as a cushion during inflationary periods. Moreover, investors can make reliable forecasts in different regimes, while hedgers will turn to gold and maybe silver particularly during crisis, while using palladium as a portfolio diversifier regarding investing in precious metals. Consumers’ purchase decisions for durable goods would be more accurate if they understand the relationship between the commodities since these durables are made from some of these metals. Moreover, major oil importers/exporters as well as oil traders may benefit from these findings by monitor oil price changes especially post crisis. Keywords: GARCH, generalized forecast error variance decomposition, generalized impulse response, information transmission, Markov-Switching VEC model, oil prices, precious metal prices, regime-switching, TGARCH volatility. …………………………………………………………………………………………………………………………